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The pace of transition towards
commodity generics in Germany is
accelerating ahead of our expectations;
the presence of marginal pricers will
enable German payers to continue to
drive down prices
The fight for market share demands new
product launches, increased scale and
vertical integration to defend sales and
margins
We believe these developments will
continue to depress sales growth and
margins for incumbents (Sandoz,
STADA) but create opportunity for
players structured for commodity
markets (Teva, Betapharm)
Our Overweight-rated stocks are Dr.
Reddy’s (REDY.BO, TP INR701), STADA
(STAGn.DE, TP EUR40) and Teva
(TEVA.TA, TP USD52); we reiterate our
Underweight rating on Novartis
(NOVN.VX, TP CHF49)
Investment summary
Accelerating commoditization
We believe that in the long term branded generics
markets will transition to a commodity structure
(Generics, going forward, 30 June 2008). We
have expressed the view that the pace of transition
will vary between markets depending on marketspecific
factors. Therefore, the commoditization
of the German generics market is in line with our
expectations. However, the pace of transition is
accelerating ahead of our expectations.
Bringing the issue to the fore was STADA’s
announcement on 28 July 2008 when it
disappointed the capital markets with its very
cautious earnings outlook for 2H 2008. The main
reason for the downgrade to expectations came
from a weaker-than-expected German generics
market in 2H 2008. STADA said that further price
declines and higher-than-expected margin pressure
from discount contracts may weigh heavily on the
group’s earnings in the second half of 2008. In our
view, this is not a STADA-specific issue but a
structural issue that will impact all participants in
the German generics market.
The declining prices and eroding margins are a
result of government interventions through public
healthcare insurance companies that are
increasing the number of drugs covered by
discount contracts while driving down prices
within the discount contracts. We believe that to a
large extent the government has been successful
in its interventions due to the increasing presence
in Germany of capable commodity generics
companies like Teva who are willing to be the
marginal pricer. This suggests that the price
erosion in the future will continue to be driven by
the marginal pricers and not the current large
incumbents (ie, Sandoz or STADA).
We believe that the new tender round of the AOK,
Germany’s largest public health insurance
company, may trigger additional sales and margin
pressure in the coming months. In our view, the
presence of companies like Teva and Betapharm,
which have critical size in Germany and a cost
structure to price compete in commodity markets,
and other low-cost providers will allow the
government and the AOK to succeed in their
efforts to bring down prices.
Data from STADA suggest that prices for
generics are down c10% y-o-y and we believe that
the recent developments suggest that pricing
pressure could intensify over the next few years.
Our estimate is that on average the prices of
generics on discount contracts in Germany are at
least 2-3x higher than the prices in the US; this
suggests substantial leeway for the prices to come
down further. We understand that the prices being
quoted in the AOK tenders are only slightly better
than the prices of commodity generics in the US.
Finally it is important to note that market research
services estimate that the portion of commodity
generic drugs in the “genericable” German market
is currently 61%. This further suggests that the
commoditization of the market has a way to go.
Creating winners and losers
We believe that the current developments in
Germany are not solely linked to STADA. We are
of the view that the increasing price erosion and
margin pressure affects all players in the German
generic market.
We believe that the key questions are the impact
that the price declines and the opening of the
market (through discount contracts and tenders)
will have on incumbents and potential
competitors. In our view, companies that can
generate volume growth and run a low-cost
infrastructure will benefit from the trends outlined
above while others will suffer.
Our analysis suggests a flat to declining German
generics market though 2012. Therefore, top-line
performance will depend on the ability to gain
market share. Since most of the market share
gains will come through aggressively bidding for
discount contracts this will have negative
implication for margins of incumbents whose cost
structure is not optimized for a commodity market
structure, at least until the cost structure can be
adjusted to the new reality. In addition, we believe
that the opening of the market that accompanies
these developments, especially the open tender
process, is a prelude to more intense competition
which does not bode well for overall prices and
margins in the market.
Large incumbents will gain share at
cost of margins
To a certain extent the larger players (Sandoz,
Ratiopharm, STADA) in the German generics
market have already been responding to the earlier
price declines (and expectations of ongoing
pricing pressure) by increasing market share at the
cost of margins. For example, Sandoz’s growth in
Germany was -6% in EUR terms in 1Q 2008, with
18.1% operating margins; growth accelerated to
2% in 2Q 2008 in EUR terms but operating
margin declined to 12.1%.
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